The Truth About Passive Investing

Some say that there is no such thing as a pure passive investing, just fifty shades of active investing. Even indexing is considered a form of active investing, because of the frequency of rebalancing.

Others point out that passive investing has nothing to do with the frequency of transactions and everything to do with the ability to impact the direction of a company you are investing in. The latter definition makes every form of public investing passive (with the exception of activist investing).

No matter the definition of passive investing you believe in, we can probably all agree that indexing has provided a cost-efficient way to invest in the growth of the world economy.

S&P 500 annual return (ex. dividends)

There’s nothing wrong in indexing (buying the S&P 500 for example), but you need to understand what exactly are you buying and decide for yourself if you can do better.

The S&P 500 goes through frequent rebalancing. It replaced ten stocks in the first three months of 2017. Some of the changes are due to acquisitions; others are due to poor stock performance. First Solar is one of the stocks that was recently replaced.

The S&P 500 is essentially a slow trend-following program run by a committee of people. The rebalancing is not based on strict technical rules. A group of people sits and decides which stocks to add and drop based on market capitalization, liquidity, domicile, float, sector classification, financial viability, length of time spent as a public company and the stock exchange it has been listed on.

The selection criteria have produced some odd timing. For example, AMD was recently added to the index, after a 500% move in the past year and a half. Do you think you can find a better entry spot?

While its timing has been often poor, over time the S&P 500 has managed to capture most long-term winners. It has kept the long-term winners and dropped the losers, many of which eventually went out of business.

About That Jesse Livermore Quote

“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.”

The above-mentioned quote is probably one of the more frequently cited in trading and investing circles. Many forget that there is an important nuance to that quote. It is the holding of great stocks in a bull market that will make you money. Try staying with a great stock through the turbulence of a bear market and then tell me how your holding is making you a ton of money. There are several things to consider:

1. You will experience several bear markets in a 40-year investment career and much more >15% declines in the stock market. You need to have a plan how to deal with them. A bear market can lead to a 50% or even 90% drawdown in any stock regardless of how great its fundamentals and its growth prospects are.
2. Not all stocks will recover after a deep market decline or it might take many years until they do. This is what market history has shown us over and over again. While well-diversified indexes tend to come back, individual stocks have had very different stories.
3. Very few can stomach a 50% or 80% drawdown in a stock. Most get scared and sell near the bottom. You think you are different and you will act cool, but you never know if you haven’t experienced it. Besides, you also need to consider the emotional toll and the opportunity cost of capital.
There is no difference between owning a stock that goes up 1000% in 10 years and owning a different stock every year that goes up 39% that year. In ten years, you will get the same return, assuming a 20% long-term capital gain in the first case and a 39.6% short-term capital gain in the second case. There’s no difference in the end result, but there is a huge difference in the experience. The first requires going through deep drawdowns which few people can stomach. The second comes with a lot smaller drawdowns and it is easier to implement.
Only 28 stocks went up more than 1000% for the past decade. This number would be a lot larger if the starting point is the bear market bottom in March 2009. This is why market timing matters.
There are more than a thousand stocks that went up more than 39% in the past year.
The odds of catching a few stocks that gain more than 39% in a year are a lot better than the odds of capturing a 1000% gainer in a decade.
Apparently, you can’t trade frequently if you manage over a billion dollars due to the sheer size of the capital. Trading often is also not an option if you don’t have the required time or the skills to do it.
The above-mentioned challenges are not new. They have been with us for decades and the financial community has found different ways to deal with them:
1. Some have decided to stick with well-diversified stock indexes and to add hedges. The result is smaller returns and smaller drawdowns. There is nothing wrong with this approach if its returns will be enough to achieve your goals. Some people have an unrefutable proof of years of poor returns that they cannot beat a plain vanilla 60/40 portfolio. Not everyone can be good at everything. It is ok to admit it. There is no shame in it. Once you do, you can dedicate your time and efforts to building other businesses and a career.
2. Indexing is not the only way to approach the challenge of inconsistent returns and market volatility. Market timing, stock picking and constantly adapting to changing market conditions can do that for you as well and deliver you a lot higher returns. No one says that is easy. It is not supposed to be easy. Otherwise, everyone would be able to do it and therefore the returns will be a lot lower. No business is easy. Each requires constant innovation and hustle.

Earnings Surprise + High Short Interest = Big Profits

Financial markets tend to underreact to genuine surprises and overreact to know threats. When a company reports better than expected earnings and sales number, it receives a positive reaction to their numbers and it has a high short interest, it can deliver hefty returns in a short period of time. CONN and RH are two recent examples. The new earnings season has just begun. It will likely provide several similar opportunities.

Innovation and Structural Edge – the Keys to Market Survival and Growth

 

Some say that discipline is the key to market success. While necessary, discipline is not enough. Otherwise, all quant systems would be always profitable. This is hardly the case. Market edges get erased all the time.

The statistical definition of a market edge is having an approach with positive expectancy.

If you have a 50% success rate and your average winner is two times bigger than your average loser, then you have an approach with positive expectancy.

Josh Brown says that any market edge is ephemeral. It cannot be sustained for long and only a few institutions have managed to adapt successfully to the constantly changing markets. Finding new edges on a regular basis might be very unrealistic when you manage billions of dollars.

Some market methods provide a structural market edge. A structural edge is an edge that doesn’t disappear forever, but it has a cyclical success rate. It goes through periods of making money, followed by periods of making no money. Structural edge is based on market forces that have always been a fundamental part of what moves prices: momentum, value, fear of missing out, fear of losing, range expansion and range contraction, the tendency of the market to underreact to genuine surprises and overreact to known threats.

Some say that the definition of insanity is doing the same thing over and over again and expecting different results. If you do the same thing over and over again in the market, you are guaranteed to get very different results. The same approach that makes a lot of money in a raging bull market is often a losing proposition during range-bound, choppy markets.

Trading or investing are not that different from any other business. You have to sustain a competitive advantage in order to continue to grow.

Markets change all the time. Great investors and traders innovate and adapt to constantly changing market conditions. The change might take the form of taking a break and moving to the sidelines or coming up with a new edge.

The main point of my latest book is exactly that: different setups work in different markets: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

Does Past Success Change Future Returns?

One of the top money managers and deep thinkers of our time, Howard Marks says the ultimate market truths are:

  1. Public psychology determines price action in short-term perspective.

Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of managements. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run. Anything can happen in this regard, with results that are both unpredictable and irrational.

2. Most things will turn out to be cyclical and eventually mean-revert.

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence: • Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Marks also believes that past performance impacts future performance in a big way:

If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.

In the quote above, Howard Marks talks about assets. Does the same principle applies to trading and investing systems? In business, when a company has very high-profit margins, it attracts competition, which eventually significantly reduces those margins.

What happens if too many people start to apply the same market strategy? Usually, that same strategy stops to work for awhile. Faced with poor returns, many will move on and try something new. Then, all of a sudden that same strategy miraculously starts to work well again. This is a basic market principle – anything that works well for the long-term, has to go through short-term periods of not working (losing money).

If everyone becomes a value investor, deep value opportunities will become more scarce. They will likely come once every five or ten years near the bottom of big bear markets. Traditional, long only value investing is hard during prolonged bull markets when a lot of money chases very few good opportunities. Warren Buffett realized relatively early in his career that value investing is not scalable. Then, he switched to buying great businesses at reasonable prices. A true value investor is basically forced to look for short opportunities during much of his career while he is waiting for the next bear market to create incredible long opportunities.

What happens if everyone becomes a momentum investor? Does momentum investing stops working or price trends last even longer and deliver even higher returns? Or maybe, trends become shorter in duration, but a lot more intense and as a result, we see moves that used to take a year to happen in one or two months?

When happens if most people become passive indexers? Correlations are likely to rise further, which means that great businesses will become very attractive deals during market corrections and crappy companies will overshoot to the upside during bull markets and eventually turn into great short opportunities.

In the financial world, you have two basic choices:

  1. Stick to one market approach and go through periods of big drawdowns.
  2. Have several approaches and apply the one that best fits the current market.

I am not saying that one of those approaches is right and the other is wrong. One requires less time and efforts. Thr other significantly reduces drawdowns and potentially can deliver higher returns. One is a science and the other is an art. Art is usually a lot harder.

My strategy is to be flexible and adapt to the ever-changing markets.